CEO ego best indicator of financial fraud, study says

Apparently, the most reliable indicator of financial fraud is not good corporate governance practices, but rather, the ego of the chief executive.

“Governance doesn’t seem to matter,” says Michel Magnan, one of three authors currently conducting further studies into financial reporting fraud in Canada. “It looks good but it doesn’t substantively have the impact we’d hope for. You need to go beyond process,” he says.

If you want to understand fraud, according to Prof. Magnan, of the John Molson School of Business at Concordia University in Montreal, you need to cast beyond rules and regulations and look to the corner office.

“Managerial hubris,” fuelled by “overconfidence” and “arrogance” is what “ignites and accelerates” the propensity of senior managers to commit, or be oblivious to, value destroying behaviour, he says.

Prof. Magnan is part of a trio of researchers who are expanding their initial study, “Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Fraud,” released in 2009. Although the revised report is not due out until next year, the data is confirming their earlier findings that when all else is considered, the size of the CEO’s ego is a more reliable indicator of financial fraud at a company than the makeup of the board of directors, the audit committee or the external auditors.

This discovery seems to fly in the face of the accepted conventions upon which a massive, multi-million-dollar governance industry has been built in the past 10 years in the name of corporate fraud prevention. More importantly, the preliminary findings have the potential to erode the public’s confidence and undermine the perception that financial fraud can be controlled with tighter mandatory regulations and greater oversight. At the very least, they should merit further investigation by regulators, corporate governance experts and publicly-traded companies that spend millions of dollars annually in the name of best practices.

In their 2009 review, Prof. Magnan and his colleagues Denis Cormier of L’Université du Québec à Montréal and Pascale Lapointe-Antunes at Brock University in St. Catharines, Ont., reviewed 15 publicly-traded companies embroiled in financial reporting fraud between 1995 and 2005, including CINAR Corp., Livent Inc., Philip Services, and Hollinger Inc.

The academics found that the governance attributes of those companies involved in financial reporting fraud were generally no different than the corporate practices at companies that did not experience such criminal behaviour.

In fact, the authors could not identify a pattern that would distinguish the governance of a company felled by fraud, and one that is not.

“Many of the things we take for granted from a governance perspective do not seem to matter in terms of different firms that are subject to fraud and those that aren’t,” Prof. Magnan explained in an interview.

One area the authors are exploring further is the question of why business figures risk their reputations to engage and pursue fraudulent activities. And why does it seem to happen more often than not in high-profile firms that are media and market darlings?

“At some point you believe your own press,” Prof. Magnan says of some CEOs. As a result, that creates a culture of “yes” people within an organization because few dare to contradict top management.

The 2009 study described CEOs who cooked books as almost inevitable: “Like moths attracted to the flames that ultimately kill them, managers under the spotlight will gain in self-assurance and a feeling of invincibility, thus leading them to take more risks in their fraudulent activities.”

More unsettling is the possibility that corporate directors, auditors and regulators equipped with a bevy of rules and regulations don’t seem to be able to prevent financial reporting fraud when dealing with successful and highly reputable executives.

By suggesting that corporate governance may be more a panacea than a solution, Prof. Magnan and his colleagues have offered some thought-provoking morsels. Their 2009 study, and its revised companion, should cause regulators who have imposed all these rules, corporate directors who are forced to follow them, and investors who have come to rely on them, to rethink, and possibly, recalibrate their expectations of corporate governance practices.

For his part, Prof. Magnan acknowledges there are limitations to his group’s study paper. Even so, it’s an unsettling prospect that the era of governance reform, kick-started by the introduction of the Sarbanes-Oxley act in the U.S., may not be enough to keep corporate behaviour and balance sheets honest. Or worse, may even be “a washout,” he says.

“The fact that it [governance] doesn’t seem to matter is quite troubling. Are we missing the boat?” says Prof. Magnan.